COST ANALYSIS

The theory of cost is important to

a manager because it provides
the foundation for two important
production decisions:

1) whether or not to shut down

2) how much to produce

Also, this chapter supports the

theory of supply.
1
“Buy low and sell high”

Increasing competitive pressures,

changing technology, and customer
demand have made it harder for
firms to achieve high profit margins
by raising their prices
 cost management, restructuring,
downsizing etc.
 outsourcing and relocation of
manufacturing facilities to low-
wage countries
 mergers, consolidations, and
then reduced headcount 2
 Choosing Output:
COSTS REVENUES
Technology
& costs of Demand
hiring curve
factors of production

TC curves AC
(short & (short & AR
long run)
long run)

CHECK: produce in SR?

close down in LR?
MR
MC
Choose output level 3
Which Costs Matter?

 Opportunity vs. accounting cost

 Opportunity cost is the cost associated with
opportunities that are foregone by not putting
resources in their highest valued use
 Accounting cost considers only explicit cost,
the out of pocket cost for such items as wages,
salaries, materials, and property rentals

 Sunk vs. incremental cost

 A sunk cost is an expenditure that has been
made and cannot be recovered--they should
not influence a firm’s decisions

4
Costs in the Short Run

 Total output is a function of variable

inputs and fixed inputs
 Therefore, the total cost of production
equals the fixed cost (the cost of the
fixed inputs) plus the variable cost (the
cost of the variable inputs)
 Fixed costs
 costs that do not vary with output levels

 Variable costs
 costs that do vary with output levels

 TC = FC + VC
5
Costs in the Short Run continued

Marginal Cost (MC) is the cost of

expanding output by one unit.
Since fixed cost have no impact
on marginal cost, it can be
written as:

∆ VC ∆ TC
MC = =
∆Q ∆Q
6
Costs in the Short Run continued
 Average Total Cost (ATC) is the cost
per unit of output, or average fixed
cost (AFC) plus average variable
cost (AVC)
 This can be written:

TFC TVC TC
ATC = + =
Q Q Q

7
The Determinants of Short-Run Cost

 The relationship between the

production function and cost can
be detected by looking at the
relationship between either
increasing returns (to a factor) and
cost, or decreasing returns (i.e.
when the law of diminishing returns
takes effect) and cost:

8
The relationship between the production
function and cost

Increasing returns and cost

 With increasing returns, output is
increasing relative to input and
variable cost and total cost will
fall relative to output
Decreasing returns and cost
 With decreasing returns, output is
decreasing relative to input and
variable cost and total cost will
rise relative to output
9
SR Cost Curves for a Firm
 Unit Costs
 AFC falls continuously and
 MC equals AVC and ATC at their minimum
 Minimum AVC occurs at a lower output
than minimum ATC due to FC
P
100 MC

75

50 ATC
AVC
25
AFC
10
0 1 2 3 4 5 6 7 8 9 10 11 Output
The Firm’s Short-Run Output Decision
 Firm sets output at Q1, where SRMC=MR
 subject to checking the average condition:
 if price is above SRATC firm produces Q at a profit
1 1
 if price is between SRATC and SRAVC firm
1 1
produces Q1 at a loss
 if price is below SRAVC , firm produces zero output
1
£
SRMC

SRATC
SRATC1
SRAVC1 SRAVC
SMC = MR
MR
11

Q1 Output
The firm’s long-run output decision
 The decision:
 If the price is at or above LAC1, the firm
produces Q1.
 If the price is below LAC the firm goes out
1
of business£
 LMC always
passes LMC
through the
minimum point LAC
of LAC.

AC1
LMC = MR

MR
Q1 Output 12

(goods per week)

 The firm’s output decisions – a summary

Marginal condition Check whether to

produce
Short-run Choose the output Produce this output
decision level at which MR = unless price lower than
SRMC SRAVC. If it is, produce
zero.
Long-run Choose the output
decision level at which MR = Produce this output
LRMC unless price is lower than
LRAC. If it is, produce
zero.

13
 Long-Run Cost Function

The long-run total cost curve describes

the minimum cost of producing each
output level when the firm is free to vary
all input levels.

One of the first decisions to be made by

the owner/manager of a firm is to decide
the scale of operation (size of the firm).

14
Long-Run Average Cost
The LAC is a graph that shows the
different scales on which a firm can
choose to operate in the long run. Long-
run average cost (LRAC) is often assumed
to be U-shaped:
Average cost

LRAC

Output 15
Economies of Scale
However, economies of scale occur
when long-run average costs decline
as output rises:

Average cost

LRAC

Output
16
Economies of Scale continued

 A cost related concept1

 When a company is experiencing
economies of scale its LRAC declines as
output is increasing

 Diseconomies of scale:
LRAC increasing as output increasing

1
Compare with returns to scale which is a
production concept! 17
Long-Run Cost Function: Displaying
Economies/Diseconomies of Scale

LRAC

MC increasing

Q
Economies of scale Diseconomies of scale
18
Economies of scale can be classified
as
a) External economies of scale
advantages that a firm gains from the
expansion and size of the industry as
whole ⇒ industrial clusters

b) Internal economies of scale

advantages that a firm gains from
increasing the scale of its own
operation

19
Why can a firm become more efficient as
the scale of production rises?

 Technical economies
 Marketing economies
 Financial economies
 Managerial economies
 Risk-bearing economies
 Administrative economies

20
Why can a firm become more inefficient
as the scale of production rises?

Diseconomies of scale:
 Large enough operation may increase
input prices
 Disproportionate rise in transportation
costs
 Red tape
 Management coordination problems
 Labor specialization and repetitive work
too little stimulation, productivity suffers

21
 Primary reason for long-run scale
economies (diseconomies) is the
underlying pattern of returns to scale
in the firm’s long-run production
function
 Increasing returns to scale lead to
economies of scale and decreasing
returns to scale leads to
diseconomies of scale

22
Using LRAC as Decision-Making Tool

 Which plant size to choose?

 Both production cost information
and accurate demand forecasts
are necessary
 The cost structure of the industry
will determine the competitive
structure of the industry

23
 The long-run average cost curve LRAC:
an envelope of short-run cost curves

Each plant size

Average cost

SRATC2 SRATC1 SRATC4 LRAC is designed for

SRATC3 a given output
level
So there is a
sequence of SRATC
curves, each
corresponding to
Output a different optimal
output level.
In the long-run, plant size itself is variable,
and the long-run average cost curve LRAC is
found to be the ‘envelope’ of the SRATCs
24
The existence of economies of scale means that
in the long run, as the firms increases its scale
of operation, the LRAC of production falls.

Each individual scale

of the firm will still
SRMC be subject to
diminishing returns
SRAC
Costs per unit ($)

and have a U-shaped

SRMC SRAC curve.
SRAC
SRMC
SRAC

LRAC
Units of output
TU-91.113 Managerial Economics / Hannele Wallenius
Minimum Efficient Scale
 A firm can not expect always to achieve
economies of scale when it expands: at
some point it is likely that the further
increase in size does not produce any
reduction in the average cost per unit
 minimum efficient scale (MES)

LRAC

MES Scale of firm 26

Increasing LRAC: Diseconomies of Scale

LRAC
SRMC
Costs per unit ($) SRAC

SRMC
SRAC
SRMC
SRAC

Units of output
TU-91.113 Managerial Economics / Hannele Wallenius
Constant Returns to Scale

 Constant RTS refers to when an

increase in scale of operation leads to
no change in average costs per unit
produced ⇒ LRAC is horizontal
 when the firm doubles the use of
inputs, it will double output as well
as its costs

28
Production with Two (or more)
Outputs--Economies of Scope
 Economies of scope exist when the
unit cost of producing two or more
products/services jointly is lower than
producing them separately
 producing related products, products
that are complementary
 the average total cost of production
decreases as a result of increasing
the number of different goods
produced
29
Why Advantages May Exist

For example:
1) Both products use same
inputs (capital and labor)
2) The firms share
management resources
3) Both products use the same
labor skills and type of
machinery
30
Economies of Scope continued

 Examples:
 Chicken farm--poultry and eggs
 Automobile company--cars and
trucks
 University--teaching and research

31
An Example: PepsiCo, Inc.

32
Economies of Scope continued

 Another example is a company like

Proctor & Gamble, which produces
hundreds of products from soap to
toothpaste. They can afford to hire
expensive graphic designers and
marketing experts who can use
their skills across the product lines.
Because the costs are spread out,
this lowers the average total cost of
production for each product

33
P&G acquires The Gillette Company
(29.1.2005)
 Both companies have complementary
expertise in health and personal care
 The companies also share complementary
technology platforms in skin care and
particularly in oral care
 Same distribution channels (Wal-Mart etc.)

34
 Degree of Economies of Scope

 The degree of economies of scope

measures the savings in cost:
C(Q1) + C(Q2) − C(Q1, Q2)
SC =
C(Q1, Q2)
 C(Q1) is the cost of producing product Q1
 C(Q2) is the cost of producing product Q2
 C(Q1Q2) is the joint cost of producing both
products

 If SC > 0 -- Economies of scope

 If SC < 0 -- Diseconomies of scope 35
Dynamic Changes in Costs--
The Learning Curve
 The learning curve measures the
impact of worker’s experience on the
costs of production
 It describes the relationship between a
firm’s cumulative output and amount of
inputs needed to produce a unit of
output
 The learning curve implies:
1) The labor requirement per unit falls
2) Costs will be high at first and then
will fall with learning 36
 The Learning Curve

Hours of labor
per machine lot 10

0 10 20 30 40 50
37
Cumulative number of machine lots produced
 The Learning Curve
Hours of labor
per machine lot
10

0 10 20 30 40 50
38
Cumulative number of machine lots produced
The Learning Curve
 The horizontal axis
measures the
Hours of labor
per machine lot
cumulative number of
hours of machine lots
the firm has produced
10
 The vertical axis
8 measures the number
of hours of labor
6 needed to produce
each lot
4

0 10 20 30 40 50
Cumulative # of machine lots produced
39
 Economies of Scale Versus Learning

Cost
($ per unit
of output)

AC1

Output 40
Economies of Scale Versus Learning continued

Cost
($ per unit
of output)

Economies of Scale
A
B
AC1

41
Output
Economies of Scale Versus Learning continued

Cost
($ per unit
of output)

Economies of Scale
A
B
AC1
Learning C
AC2

42
Output